ECB Stress Test Could Reveal Widespread Weakness

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We still have a good six weeks before the European Central Bank (ECB) reports back on stress test results, but following the Banco Espirito Santo SA (ELI:BES) bailout, expectations are already riding low, and Federal Financial Analytics, Inc co-founder and managing partner Karen Shaw Petrou thinks that the best case scenario is still pretty grim.

“At best, Europe’s banks will come under long-delayed capital pressure that — while warranted — will have the unintended effect of pushing them out of the markets in which they need to stay for Europe to come out of its prolonged slump,” she writes.

ECB: Cheap, risky sovereign debt will make banks look weak if marked to market

Petrou argues that even with EU banks shedding high risk obligations to strengthen their balance sheets without much regard for the impact they’re having on the region’s recovery, risky sovereign debt is still going to be a major problem. She says that the combination of cheap issuances from the EU periphery and yield chasing means that banks have a lot of risky sovereign debt on their books. If those bonds are marked to market just as Russia is moving into Ukraine, driving a flight to quality, then the banks will suddenly look a lot weaker.

ECB stress test results could impact G-20 negotiations

While a poor report from the ECB could scare investors away from Europe and hurt its already frail recovery, Petrou is also concerned about what effect the stress test results will have on capital, liquidity and resolution standards set to be negotiated by the G-20 in November.

“To be sure, there will be a final, hard-fought resolution standard, but in the first case that could have come under it – the failure of Portugal’s Banco Espírito Santo – Portugal went back to the old days and rescued senior creditors and uninsured depositors,” she writes. “The Eurozone’s banks thus face their stress tests with a toxic mix of high leverage at a time of significant market uncertainty compounded by continuing moral hazard.”

EU governments won’t be eager to accept tough standards if their own banks are weak, central banks are either reluctant to act or restrained by their already bloated balance sheets, and the market is already nervous over Russian troop movements. But without new standards that seriously address systemic risk, we’ll just be gearing up for another financial meltdown in the future.

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